Tags: Earnings | Warnings | Hurts | Market

Earnings Warnings Hurts Market

Friday, 30 September 2005 12:00 AM

Wilkinson's Edge
The Cutting Edge of Financial Analysis

Dear MoneyNews Reader,

Since 2001, corporate America has grown profits by 15% each year. An interest rate-friendly environment, slack labor market and cheap raw materials have routinely allowed companies to widen margins and deliver value to shareholders.

But that may all be coming to an abrupt end as rising energy and commodity prices hurt companies' cost structures. Add rising interest rates and a marked slowdown in productivity growth - thanks in part to a tighter labor market - and the prospects for profit growth look a little shaky, according to a growing group of economists.

While we might be looking here at "no change in profits" rather than "no profits at all"(obviously, there is a BIG difference between the two), the prospect of a lack of profit growth is quite difficult for the market to grapple with.

HSBC Global Research in London says that U.S. profit growth will slow to zero in the first half of 2006 and that it may turn down slightly in the second half of the year.

Falling profits could send stock prices sliding and make companies reluctant to add workers, causing them to cut back on capital spending, according to High Frequency Economics.

Corporate profit warnings come in all shapes and sizes.

Take, for instance, the announcement from Brunswick Corp., a manufacturer of recreational boats. That company warned of a coming 4% fall in profits for 2005 thanks to "high fuel prices, a drop in consumer confidence and Hurricane Katrina."

Or consider New York-based JetBlue Airways, which warned that its unbroken string of profitable quarters - which dated back to 2002 - was at risk thanks to rising fuel prices.

So the argument may be balanced.

The consumer is at risk as real wage growth is very low, allowing for inflation to make us worse off. As a result of a drop in discretionary consumer spending, corporate profits are at risk. And weak profit growth is set to cause corporations to pull in their horns, hire and spend less.

Can it be really true? Will high oil prices really cause a recession?

Hold on. Who said anything about a recession?

My mistake. I'm confusing too much of a good thing with the view currently in vogue.

The "good thing" turns out to be global economic growth, which has pushed up oil prices. And the "vogue view" is that this is likely to choke off overall growth and send equities into a dizzy tailspin.

Talk about killing the goose that laid the golden egg!

With 72% growth in corporate profits between 2001 and 2005, economic development has been nothing short of spectacular. Personally I have a hard time swallowing the story that the economy is set to deflate on account of the growth that has gone before it.

This "analysis paralysis" begs many unasked questions.

What if wage inflation helps rebuild consumer balance sheets?

As labor markets tighten, it isn't wholly unreasonable to believe that corporations would pay up to both retain valued managers and pay more to attract new hires. In this event, a recession is hardly a forgone conclusion. In fact, the outlook for retailers and consumption is a lot brighter.

Second, what if the energy markets start to discount a recession?

What if crude oil works the kink out of the distribution pipeline and finally concludes that it's not just demand that will fall in a recession - it's also the price of crude?

Third, what if the role of government spending outweighs the drag from consumer spending?

For the last six years, the nation has spent an average of $298 billion per month at the mall. That's about $1,100 per person. The current spending provision for Hurricane Katrina is $200 billion. The major difference here is that the government package will send ripples through the economy as spending on restructuring begets more employment, wages and income.

A period of below-average energy prices could do a lot to actually stimulate the economy looking forward, especially if consumption holds up - as I expect it will - regardless of higher gas prices in the third quarter. Already as I drive around I notice that the price of gasoline has recoiled from the $3-per-gallon mark.

And I'm not alone in my optimism when it comes to earnings.

Recently, Wall Street investment bank Morgan Stanley raised the prospects for stronger earnings into 2006. Chief Equity Strategist Henry McVey predicts a 13% rise in 2005 earnings over those of 2004, but he expects a more subdued 7.9% rise in 2006.

For the remainder of 2005, we are going to have to watch two things closely. First, keep an eye on how the market reacts to further profit warnings from companies. If the current snow flurry turns into a blizzard, the roof will inevitably cave in and send the broad stock market lower.

Second, monitor companies' ability to raise prices for customers. In my opinion, inflation is not actually a bad thing.

If controlled promptly enough, it has a positive impact on spending and profits. The Fed is responding in a timely manner consistent to the threat, and unless a wage bargaining spiral evolves, a limited amount of inflation can be a good thing.


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The U.S. Dollar

I've read many an article over the past year or so explaining in no uncertain terms why the day of the dollar is over.

The most popular excuses include the bulging budget deficit and the eternally swollen trade gap.

During my trading career I have tried to search for reasoning behind price movements and use some other rationale to decide how much of the prevailing view is already "priced into" the market.

As 2004 came to a close, it was impossible to ignore the many voices telling us the same old story about why the dollar was doomed - and they were loud enough to make me change my fundamental opinion on the dollar.

The story at the time reminded me of one my favorite novels, which I read during my college days some twenty years ago.

Joseph Heller's "Catch-22" is a satirical look at the decisions made by those faced with certain annihilation during World War II. The main character was named Yossarian.

Throughout the novel, he is constantly asked to validate his beliefs and actions. At one point the army Chaplain asks him, "What if everyone thought that way?" To this, Yossarian retorts, "Then I'd certainly be a damned fool to feel any other way, wouldn't I?"

This character's role was the most thought-provoking part of the book. His accountability stemmed from a "contrarian" approach to life.

As I weighed the plight of the greenback in December, my views were indeed contrarian.

The dollar had already snowballed in the foreign exchange market. If everyone was thinking it, saying it and acting upon it, then it was more than likely that prices probably already fully discounted the idea of a dollar slide. Or at the very least, there was a strong chance that most of the move had occurred.

So as a dollar rebound developed this year, lifting the value of the U.S. currency against a basket of other currencies by 12.6%, it was no real shocker to me.

However, while some observers stick to their guns, expecting further sustained dollar weakness in the months and years ahead, I want to raise a technical observation in this week's column.

My perspective here is that the dollar's bounce looks and feels like a major turnaround. While those heavy fundamentals may return to haunt the dollar, there can be no denying the strong and real demand for U.S. dollars in the first nine months of the year.

That move has lifted the dollar up by 12.8% against the euro, 10.4% against the Japanese yen, 13.6% against the Swiss franc and 8.5% versus the British pound.

Notice in the chart below how the decline, which began in 2002, looks like it may have finished at the end of 2004.

In February, the dollar held its lows, prompting savvy buyers to start accumulating.

By April of this year, the dollar index broke through the resistance line, calling into question whether the U.S. currency was a thing of the past.

The subsequent rally has lifted the dollar well above the trendline and challenging levels not seen since July 2004.

In fact, the next target from the current 89.10 in the chart is 92.50 or just 3.8% above this week's peak. This is a key area for the dollar. If it rallies through here, the odds are we really are in a new bull rally for the greenback, which will see 100 as a target within six months.

So what's driving the dollar higher?

In my opinion, the stimulus package that accompanies the twin hurricanes is the real bottom-line driver here.

As we are fast learning, there was nothing really wrong with the American economy prior to the damage in New Orleans. In other words, the Federal Reserve's slow-but-sure policy of raising interest rates - at a time when inflation appears to be staying relatively low - was working in favor of the dollar.

However, it's also becoming apparent that the Fed is very concerned about the potential for energy-induced inflation to get a grip on the economy, especially with already-tight labor markets.

For example, two Fed members this week rattled the inflation saber.

Thomas Hoenig, a non-voting member from the Kansas City Federal Reserve, noted in a speech that "inflation is high enough to get your attention."

Janet Yellen, chairman of the San Francisco Fed, told the British Parliament that "estimates of the extent of spending are escalating, and the recovery and bounce-back - fueled by massive fiscal stimulus - could propel the U.S. economy on an unsustainable upward trajectory."

International investors find higher yields on currencies appealing - at least unless the currency faces erosion of its value, thanks to inflation.

However, we have a combination of potential inflation and a central bank that appears resolute in nipping pressures in the bud. By doing so they are boosting the appeal of the dollar - and investors are having a tough time arguing anything else.

Europe can hardly complain at the commensurate decline in the value of the euro as it serves to bolster growth, helping exporters sell cheaper goods to the world's largest consumer markets.

With short-term rates on the dollar standing at 3.75% and rising, the dollar looks appealing compared to the euro (which might pay 2%), the yen (1%) and the Swiss franc (0.75%).

The exception in the crowd is the British pound, for which the Bank of England recently reduced benchmark rates to 4.5%. Growth in the U.K. is faltering, and once again the dollar looks attractive.

While there is more to exchange rates than simply yield, growth rates and inflation, the allure of the dollar continues. The break in the downtrend since the first quarter this year may signal a bigger shift than most economists are expecting.

Commodities Corner

If I told you that the surge in the price of sugar this week was due to the price of gas, would you believe me - or would you think I'd gone mad?

Well it's true enough for me to report to you about it.

The price of sugar traded on the New York Board of Trade reached a five-year high this week, mainly on concerns over gasoline prices, which surged following the "pipeline kink" served up by the twin hurricanes.

You see, Brazil - the world's largest exporter of sugar - faces a choice between two buyers. First, the rest of the world buys sugar as a sweetener. Second, Brazilian ethanol producers use sugar cane to produce fuel that serves to compete with gasoline.

So this week as gasoline futures on the New York Mercantile Exchange approached record levels again, fears rose that a growing proportion of Brazil's sugar harvest would be diverted to ethanol production, which is expected to rise 5% to 16.9 billion liters in 2005.

Ethanol can be distilled from corn and sugar and is blended in conjunction with gasoline to produce a cleaner-burning fuel. Already Brazilians are switching to ethanol-capable cars.

According to Brazilian automaker statistics, the share of alcohol- and ethanol-powered cars recently rose to 61.7%, a percentage that has doubled in just nine months. Merely eighteen months ago only 16 out of every 100 cars driven ran on the mixture. Brazilian car sales are up 16% alone on the year to August.

While in 2005 the global shortage of sugar ran at 3.08 million metric tons, 2006 should see a lesser supply deficit of 1.07 million metric tons.

Shares in Archer Daniels Midland Co. (ADM), the world's leading ethanol producer, rose on the expectation that the corn-based fuel would lead to better profits in the coming years. Earlier in September, ADM announced plans to expand ethanol production by one-third to 1.6 billion gallons by 2008, thanks to rising demand.

In 2005 approximately 4 billion gallons of ethanol will be added to gasoline supplies. The recent Bush Energy Bill has called for that volume to increase to 7.5 billion gallons annually by 2012.

ADM's competitor, Cargill Inc., also recently announced plans to build ethanol plants in Indiana, Nebraska and Ohio. That would allow them to produce 100 million gallons of the fuel annually starting as early as 2006.

In last week's Wilkinson's Edge I commented on the potential supply disruptions to coffee stocks held in New Orleans warehouses.

Well, now traders are trying to get their hands on information about damage to Louisiana's sugar cane harvest. Early calculations say that as much as 9% of the crop may have been destroyed by the storms, which accounts for 1.5% of total U.S. sugar production, according to the Department of Agriculture.

The sugar chart shows the extreme nature of this week's move in vivid contrast to the slide in corn.

Despite a recent sharp run-up in corn futures by some 25%, corn has found few buyers recently, due to a surplus of corn crops.

Tim Hannagan, grains analyst at Alaron Trading in Chicago, says that the market was anything but optimistic.

"With the period of highest supply still looming and the market not expecting any help from the export sector, prices [of corn] look likely to press lower unless developments in the oil market, soybean oil and inflationary psychology make it more difficult to press below the $2.00 level."

Tim suggests that while current oversupply concerns probably justify weak nearby prices (December 2005 and March 2006), there is little justification for soggy prices thereafter since ethanol supplies might be quickly depleted as gasoline supplies are disrupted.

While sugar soars on account of tight supplies, corn expiring in July or September of 2006 might present futures speculators with a decent risk/reward opportunity.

Asian Stocks

The Standard and Poor's 500 Index stands pretty much flat for the year (up 0.7%).

That's a pretty disappointing performance, I have to admit. However, equity investors should look elsewhere. It's a stark contrast to major European benchmarks, which stand between 15 and 20% higher for 2005.

But take a look at Asian stocks in the following chart, where I have included a side-by-side comparison of the S&P 500 and those indices of South Korea and Japan.

The 37% year-to-date gain in Korean stocks builds on a strong finish to last year, leaving the index up 47% since this time one year ago. A 17% rise in Japanese stocks this year leaves them 25% higher than one year ago.

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The awakening of Japan, the world's No. 2 economy, has played an enormous role in instilling confidence in Asia.

Financial stocks gained as credit-rating agency Standard & Poor's was said to be poised to raise ratings on 25 banks in the region. This follows a massive clean-up operation to reduce bad lending habits at banks. The summer economic revival has helped the prospects for improved lending, which will further stimulate the economy.

In fact, Morgan Stanley's international Asia-Pacific index hit its highest level since August 2000 this week as stock buyers binged. In the last three months alone Asian financial stocks have risen as much as 17%.

The situation has improved dramatically since the 1997 Asian crisis. Some $500 billion in state aid has worked its magic on the financial system, resulting in the alluring prospect of profitability ahead for the banks.

Andrew Wilkinson
Senior Newsletter Editor


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Wilkinson's EdgeThe Cutting Edge of Financial AnalysisDear MoneyNews Reader,Since 2001, corporate America has grown profits by 15% each year. An interest rate-friendly environment, slack labor market and cheap raw materials have routinely allowed companies to widen margins...
Friday, 30 September 2005 12:00 AM
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